EL: It seems your investment thesis for both long and short ideas is to find “obvious ideas.” To buy shares in high-quality companies at low prices, investors must often overlook a “stigma” – such as LabCorp’s (NYSE: LH) reputation for being mature and stodgy (I covered this company as an analyst). Can you give us your ideas on what “stigmas” should be overlooked and which ones shouldn’t? How do you avoid “value trap”?
ZA: To the extent that we can find simple, easy-to-analyze businesses that are obviously very cheap, we naturally prefer those. In investing, you don’t get extra points for “degree of difficulty” – this is why Warren Buffett talks about looking around for 1-foot bars to step over rather than trying to learn how to jump over 7-foot bars. Unfortunately, after the run-up we’ve seen in small-cap stocks over the past five or six years, the market hasn’t offered a lot of simple, high-quality businesses trading at less than 10 times free cash flow for a while, so we’ve had to work a little harder to find good ideas.
MR: As for “value traps,” it’s probably helpful to define the term. I’ve seen certain stocks labeled as value traps just because they’ve traded at low multiples for an extended period of time. That’s not necessarily a value trap. For instance, back in 2003 we owned one so-called value trap, Lone Star Steakhouse, which worked out very well for us, rising from $18 to $27 with 2 years and paying large dividends all the way. A true value trap is a stock that trades at a low multiple to earnings, free cash flow, book value, or some other statistical metric – but where that low multiple is not indicative of being undervalued. Typically the low multiple is justified because the company’s current earnings power is at risk of being impaired, or else because the business is prone to becoming obsolete within the next decade.
The best way to avoid value traps is to never buy a stock just because it appears cheap on some statistical multiple. Back in 2002 and 2003, there were a ton of good businesses at low multiples – and most of them were genuine bargains. But today, a low-multiple stock is far more likely to be a subpar business facing some nasty risk factors – i.e., a value trap. Value investing, contrary to how it’s often portrayed by financial academics, does not merely equate to buying low-multiple stocks. Intelligent value investing requires thinking through all forward-looking assumptions, and thereby figuring out what a business is worth. Some businesses justify low multiples; some justify high multiples. It all just depends on the nature of the business – competitive advantages, growth prospects, and the like. It’s by this process of independent thinking and testing our assumptions that we’re able to weed out value traps, while also occasionally finding gems that carry an unjustified stigma.
ZA: LabCorp is actually a very simple business and was one that we felt was very predictable. From a valuation standpoint, we were able to use free cash flow and basic free cash flow multiples as a starting point on the valuation. At the time of our original purchase of LabCorp back in 2003, I don’t think it was cheap because of any stigma so much, but rather it was simply not fully appreciated for the outstanding qualities it possessed. It was an excellent business but an “in between” stock. It was a growing business, but not growing fast enough for the growth-type investors. It was very reasonably priced, but not cheap enough for the hardcore value investor. The company’s financials were somewhat distorted by a history of acquisitions that inflated the P/E ratio, turning off investors attracted by that metric. It wasn’t in the S&P 500 at the time we purchased it, either.
In any event, over the past couple of years, Labcorp has been such a stellar business, and the company has delivered excellent earnings and cash flow and bought back a ton of stock. Also, the company was added to the S&P 500, and I think people just woke up to the fact that LabCorp was a very good business trading at a big discount to the S&P 500. Even now the company isn’t overpriced by any means. In short, any good company that becomes undervalued gets there either because investors don’t recognize it as a good business, or because a number of investors don’t want to own it right then because of some recent negative news.
It’s part of our job to try to figure out what the negative argument on any idea might be, and try to determine if the negative thesis has merit. Sometimes, we simply can’t figure out why a stock is cheap, and in those cases, we simply try to cover all the bases in our research. We’ve learned over time to trust our own judgment when we can’t find any valid reason or identify a stigma that might explain why a given stock might be cheap.
EL: Please provide a “cradle to grave” description of one of your successful investments.
MR: Alliance Bernstein (NYSE: AB – formerly Alliance Capital) has been a longtime resident in our portfolio, off and on, for much of the past four years. We found the stock back in 2003, when it fell sharply amidst the mutual fund scandal and industry-wide investigations by Eliot Spitzer. In late 2003, AB traded for around $30 per share, with a dividend yield of 6% and a multiple of less than 10 (times) structural FCF. One of the reasons AB remained cheap for so long is because it has an unusual corporate structure. The publicly traded entity is a limited partnership which owns roughly one-third of the parent company. This structure requires that investors take a “look-through” approach to the overall parent company (the Alliance Bernstein operating partnership) in order to understand the true worth of the publicly-traded share (Alliance Bernstein Holdings L.P.).
Fortunately, we were inclined to do the work because we love asset managers – an industry we know a thing or two about. The asset-management economic model has no inventory or receivables risk, plus it has the potential for economies of scale as assets under management grow. Particular to AB, we really liked the 2001 acquisition of Sanford Bernstein, which brought a value-investing philosophy to a company that previously has been geared primarily toward growth investing.
The stock was a good performer in 2004 but really took off in late 2005 thanks to rapid asset inflows into its value and international investment products. By early 2006, we had the opportunity to sell at just over $60, which was where we pegged conservatively fair value, based on a DCF (discounted cash flow) model and conservative growth assumptions. After we sold, the stock went as high as $72, but within six months it was back to $60. By that time, we had the benefit of two more quarters of financial results, which showed that AB’s growth in profits and FCF had been much stronger than we’d previously anticipated. As such, we saw fit to increase our fair value estimate to the low $70s.
With AB just over $57, in August 2006, the stock was priced at around 80% of our new fair value estimate, making it a buy once again. As the stock market turned higher in fall 2006, so too did AB and we quickly got our chance to sell when the stock got north of $70. Once again, we were probably overly conservative in our assumptions, as AB has gone to much higher levels (over $92 as at 17 Apr 2007). But we were satisfied with our outcome, and we’ll continue to follow the AB story and look to buy it again if it falls back to undervalued levels.
EL: Please provide a “cradle to grave” description for one of your unsuccessful investments.
ZA: Bandag (NYSE: BDG) is a stock that we had originally purchased back in 2002, when we saw it as a deeply undervalued, cash-flow producing business at very low multiples to cash flow. The company was the market share leader in re-treading equipment for tires and owned patents on the method, in addition to selling the equipment and rubber for the actual re-treading. The company had a long history of cash generation, increasing dividends, and intelligent share buybacks. In addition, at that time it was in the process of divesting a relatively unprofitable chain of retail tire stores that ultimately freed up a lot more cash and highlighted the true profitability of the underlying business. We late sold at a nice profit.
About a year later, in late 2004, the stock fell way back and we purchased Bandag again. Unfortunately, this time around the company was suffering from significant inroads being made by cheaper new tires from Asia, while input costs were also increasing. These two factors were rapidly squeezing Bandag’s margins. Bandag was compensating for this by directing its cash flow to a new chain of truck lubrication and service stations, which at the time we thought might be a good idea. Unfortunately, it became apparent to us after several quarters that this initiative was never going to have the returns once generated by the core business, and that the core business, while likely to survive, was likely to be far less profitable going forward as globalization took its toll. We sold our shares at about a 20% loss from our original purchase price the second time around in order to buy some other things that looked better to us at the time.
In a final ironic twist, Bandag later announced it would be bought by Bridgestone at a price that would have represented a very nice return on our original stock price. There’re a couple of lessons in this: First, in our modern world the competitive moat around a business can deteriorate rapidly. Second, in looking back at our research on the company, we actually believe that selling was the right thing to do, and that there was no way to have seen a buyout coming because Bandag had been a family-controlled company for decades and there was no indication that was going to change. We see their having to sell that business as confirmation of weakness, not strength. That’s not to say we would’ve minded having a good outcome for our troubles instead of a bad one.
In summary, we think our original decision to buy Bandag was good, as was our decision to sell. The second purchase of Bandag, even though it was only two years later, was flawed – Bandag’s fundamentals had deteriorated, and the stock had become a great example of the “value trap” that Matthew described earlier. Of course, had we taken longer to realize our mistake and gotten the benefit of the favorable acquisition price, we might still have enjoyed a good outcome from a poor decision.
Check back later for the third and final part. Again, great insight from Centaur: Sometimes value is right under your nose, as with LabCorp, and sometimes you have to look from a different angle, as with Alliance Bernstein.